In my first part of this series, I had explained what is a share and how a business evolves. Today I shall discuss the much bandied terms like EPS, PE ratio, Dividend etc. A2Burgers Pvt Ltd commenced their business with Rs 400,000 of capital. They purchased some equipment, hired two waitresses and rented a shop in Malwa Complex, Mhow.In the first three months they ran into a loss. Nobody knew of their Burger Joint. They had not spent money on marketing and they lost Rs10,000. If they were publishing quarterly results of their company, their quarter 1 or Q1 results would show losses. Gradually their business picked up and in the next three months they sold more burgers as the new Young Officers'(YO) course had commenced. And by 31 Mar 2012, A2 burgers had sold burgers worth Rs 550,000.
The Application of Funds in their balance sheet looked something like:-
Application of Funds
Gross Block 100,000 (Purchased Equipment)
FD in Bank 100,000
Sundry Creditors 200,000 (Money to be paid to Suppliers of raw materials and
salaries)
Total Assets 400,000
Now their Profit and Loss statement will be made for the full years’s business.
It will show
Income
Sales 550,000 (By selling burgers)
Other Income 9,000 (Interest on FD)
Total Income 559,000
Expenditure
Raw Materials 300,000
Power & Fuel 50,000
Employee Cost 120,000
Selling & Admin 19,000
Total Expenses 489,000
Gross Profit 70,000 (Total Income-Total Expenses) but Operating Profit will be 61,000 because Rs9000 came from interest and not from the main business or operations of selling burgers.
This is also called as PBDIT(Profit before Depreciation, Interest and Tax)
Interest 27,000 (On the loan given by grandfather)
Depreciation 10,000 ( To cater for future replacements of machines)
Profit Before Tax 33,000
Tax 0
Profit after Tax (PAT) 33,000
Now, this part of the earnings can be used by shareholders for either distribution as profits in that case it will be called Dividend. Or they can further keep this money to expand their business, in that case it becomes retained earnings.
Now let us see some ratios.
A2Burgers had a Net Profit or PAT of 33000 on a share capital of 100,000. The total number of shares were 10000. Hence, Earnings or profit per share (EPS) = 33000/10000=Rs 3.30
A higher EPS denotes that the company is earning good profits.
Let us assume, this company’s shares were quoted in the market and were being bought and sold at Rs 29.70 (Current Market Price or CMP)
The CMP to EPS ratio in that case will be= 29.70/3.30 = 9
This ratio is the Price to Earnings ratio or PE ratio. A lower PE ratio shows that the market is pricing the share of this company at a cheaper price compared to its earnings. But one needs to further examine the reasons before jumping to buy.
The Market Cap of A2Burgers would be 10000(shares) x 29.70 (CMP) = Rs 297,000 The value of their complete business is 297,000
If you notice, the balance sheet of this company has too much debt. A major component of their profit is going into paying the interest on the debt. Initially businesses do require loans and debt to grow. But the Debt Equity ratio should not be too high. In this case it is very high. Debt is 300,000 and equity is 100,000 So the Debt Equity Ratio is 3. Ideally it should be less than 1. The best businesses for a share holder to own are debt free businesses. The entire profit is then available to be distributed to shareholders or can be used to grow business.
The so called Fast Moving Consumer Goods(FMCG) giants like Gilette, Colgate, HUL are all debt free good companies (though expensive at today’s prices).
One good debt free business which is currently worth investing in at prices below Rs27 is ILF&S Investment Managers. It is profitable, debt free, cheaply available, good dividend paying, immune to Dollar/Rs Index, immune to oil price hikes. Analyze and then Go Buy it.